Why Apple Pay will succeed

In an interview, MasterCard executive Mung Ki Woo discusses more details about Apple Pay and how it works within the larger credit and debit card processing system.

Last week, I wrote about the biggest lesson that other companies should learn from Apple Pay, the new mobile payments platform that Tim Cook and company recently launched. Namely, if you focus on the customer, the results will follow. Simplicity and ease of use are the names of the game here.

To take a look at just what Apple has done, I talked with Mung Ki Woo, Group Executive of Mobile at MasterCard, one of the world’s largest credit card payment networks and a launch partner for Apple Pay.

But first, let’s take a look at how Apple Pay works.

When a credit card (or debit card with Visa or MasterCard logo) purchase is made at a retailer, three outside companies are involved in the transaction outside of the consumer and the store.

There’s the acquiring bank, which is the institution that processes the payment on behalf of the merchant. There’s the issuing bank, which is the consumer’s bank that issued them the credit card and the line of credit behind it. Then there’s the payment network, like MasterCard or Visa, that acts as the go-between for the two banks. To make things a little more interesting, American Express is both the issuing and acquiring bank, as well as the payment network, partially explaining why they make so much money.

Apple isn’t taking the place of any of these groups — instead, it’s more or less taking the place of the company that prints the physical credit card. When a user signs up for Apple Pay, they will scan their credit or debit card with the iPhone’s camera. Then Apple will contact the issuing bank and create a new “token” (what Apple calls the Dynamic Account Number). Essentially, this is a brand new 16-digit account number that will be used for all transactions.

When a payment is attempted, the token is sent to the issuing bank and onto the payment network. Then the token is converted back into the real account number and sent on to the issuing bank, who either authorizes or declines the transaction.

The merchant doesn’t need to do anything special with the Apple Pay token — they pass it along like any other card number. All the back-end work is done by the payment network and issuing bank.

“The beauty of this system is that it happens in the background,” says Woo. With Apple Pay, you disconnect your real card from what is used to complete the transaction. Theoretically, if a consumer used Apple Pay for all their purchases, their actual credit card number would be merely an account number used to pay their bill.

Though there are numerous contactless payment systems that use near-field communications (NFC) — which, incidentally, is how Apple Pay works — Woo compares Apple Pay to the original iPod.

“The iPod was not the only MP3 player, and it was not even the first MP3 player. However, it was a very good product with a very compelling consumer experience. Here, we have a bit of the same thing.”

In effect, Apple is taking advantage of a number of assets that the payments industry has already created — contactless payments via NFC, the digital token account number, and much more — but it has solved the chicken-and-egg problem.

Retailers were waiting for consumers to adopt NFC before rolling out contactless payment readers, and consumers were waiting for retailers to jump on the bandwagon. With Apple supporting NFC in tens of millions of new iPhone 6 models, retailers will be eager to jump on board — and they have. A total of 2.5 million retailers worldwide support NFC payments, and that number is going to skyrocket going forward.

In addition to putting NFC payments in the hands of millions of its customers, Apple has negotiated unprecedented deals with banks. Apple will reportedly get 0.15% of every Apple Pay transaction from the issuing banks, which is something unheard of in the industry. While it’s unlikely this will make much of a dent in Apple’s earnings (it would amount to $150 million on $100 billion in purchases), it will cover the costs of the program on Apple’s end and potentially set up for a bigger payday in the future. Some $12 billion in swipe payments are made in the United States every day.

For consumers, the ability to scan their own credit cards with their phone and then make payments — with no other steps involved — means higher user adoption… and for banks, it means more payments made.